Chapter
3
Securities Markets
Bodie, Kane, and Marcus
Essentials of Investments
Tenth Edition
3.1 How Firms Issue Securities: Primary vs. Secondary
Primary
Secondary
New Issue Created/Sold Current owner sells to
another party
Issuer
Receives Issuer
Does
Not
Proceeds from Sale
Receive Proceeds from
Sale
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2
3.1 How Firms Issue Securities: Private vs. Public
Privately Held
Publicly Traded
Definition
Ownership help by a small Securities sold to the
group of investors
general public; investors to
trade shares
Shareholders
Up to 499 shareholders
Financial Statements
Fewer
obligations
to Obligated
to
release
release
financial financial statements to the
statements to public
public
Primary Offering
Sold Directly to a Small Sold to the Public (often
group of Investors
with an Underwriter)
Unlimited number
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3.1 How Firms Issue Securities: IPO
• Publicly Traded Companies
• Initial public offering: First sale of stock by a
formerly private company
• Underwriters: Purchase securities from issuing
company and resell them
• Prospectus: Description of firm and security
being issued
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3.1 How Firms Issue Securities
• Initial Public Offerings
• Issuer and underwriter put on “road show”
• Purpose: Bookbuilding and pricing
• Underpricing
• Post-initial
sale returns average 10% or
more—“winner’s curse” problem?
• Easier to market issue; costly to issuing firm
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5
Figure 3.1 Relationship among a Firm Issuing Securities, the
Underwriters, and the Public
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Figure 3.2 Average First-Day Returns for (mostly) European IPOs
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7
Figure 3.2 Average First-Day Returns for Non-European IPOs
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3.1 How Firms Issue Securities: Shelf Registration
• SEC Rule 415
• Security is preregistered
• May be offered at any time within the next two
years
• 24-hour notice: Any or all of preregistered
amount may be offered
• Introduced in 1982
Why would a firm use Rule 415?
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3.2 How Securities Are Traded: Financial Markets
• Overall purpose: Facilitate low-cost investment
• Bring together buyers and sellers at low cost
• Provide adequate liquidity
•Minimize time to trade
•Promotes price continuity
• Set and update prices of financial assets
• Reduce information costs associated with investing
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3.2 How Securities Are Traded: Market Types
• Direct Search Markets
• Buyers and sellers locate one another on their own
• Brokered Markets
• Third-party assistance in locating buyer or seller
• Dealer Markets
• Third party acts as intermediate buyer/seller
• Auction Markets
• Brokers and dealers trade in one location
• Trading is more or less continuous
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3.2 How Securities Are Traded: Order Types
• Market order: Execute immediately at best price
• Bid price: price at which dealer will buy security
• Ask price: price at which dealer will sell security
• Price-contingent order: Buy/sell at specified price or
better
• Limit buy/sell order: specifies price at which
investor will buy/sell
• Stop order: not to be executed until price point hit
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Figure 3.3 Market Orders: Average Market Depth
•S&P 500: Large
Capitalization Stocks
•Russell 2000: Small
Capitalization Stocks
What does the
difference in depth
imply?
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Figure 3.5 Price-Contingent Orders
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3.2 How Securities Are Traded
• Trading Mechanisms
• Dealer markets
• Over-the-counter
(OTC) market: Informal
brokers/dealers who negotiate securities sales
network
of
• NASDAQ stock market: Computer-linked price quotation
system for OTC market
• Electronic communication networks (ECNs)
• Computer networks that allow direct trading without market
makers
• Specialist markets
• Specialist: Makes market in shares of one or more firms;
maintains “fair and orderly market” by dealing personally
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3.3 Rise of Electronic Trading: Timeline of Market Changes
• 1969: Instinet (first ECN) established
• 1975: Fixed commissions on NYSE eliminated
• Congress amends Securities and Exchange Act
to create National Market System (NMS)
• 1994: NASDAQ scandal
• SEC institutes new order-handling rules
• NASDAQ integrates ECN quotes into display
• SEC
adopts Regulation Alternative Trading
Systems, giving ECNs ability to register as stock
exchanges
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3.3 Rise of Electronic Trading: Timeline of Market Changes
• 1997: SEC drops minimum tick size from 1/8 to
1/16 of $1
• 2000: National Association of Securities Dealers
splits from NASDAQ
• 2001: Minimum tick size $.01
• 2006: NYSE acquires Archipelago Exchanges and
renames it NYSE Arca
• SEC
adopts Regulation NMS, requiring
exchanges to honor quotes of other exchanges
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Figure 3.6 Effective Spread vs. Minimum Tick Size
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3.4 U.S. Markets
• NASDAQ
• Approximately 3,000 firms
• New York Stock Exchange (NYSE)
• Stock exchanges: Secondary markets where
already-issued securities are bought and sold
• NYSE is largest U.S. Stock exchange
• ECNs
• Latency: Time it takes to accept, process, and
deliver a trading order
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Figure 3.7 Market Share of Trading in NYSE-Listed Shares
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3.5 New Trading Strategies
• Algorithmic Trading
• Use of computer programs to make rapid
trading decisions
• High-frequency
trading:
Uses
computer
programs to make very rapid trading decisions
in order to compete for very small profits
• Dark Pools
• ECNs where participants can buy/sell large
blocks of securities anonymously
• Blocks: Transactions of at least 10,000 shares
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3.6 Globalization of Stock Markets
• Moving to automated electronic trading
• Current trends will eventually result in 24-
hour global markets
• Moving toward market consolidation
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Figure 3.8 Market Capitalization of Major World Stock Exchanges,
2014
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3.7 Trading Costs
• Commission: Fee paid to broker for making
transaction
• Spread: Cost of trading with dealer
• Bid: Price at which dealer will buy from you
• Ask: Price at which dealer will sell to you
Spread = Price Ask − Price Bid
• Combination: On some trades both are paid
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3.8 Buying on Margin
• Margin:
Describes securities purchased
with money borrowed in part from broker
• Net worth of investor's account
• Initial Margin Requirement (IMR)
• Minimum
set by Federal Reserve
Regulation T, currently 50% for stocks
under
• Minimum % initial investor equity
• 1 − IMR = Maximum % amount investor can
borrow
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3.8 Buying on Margin
• Equity
• Position value – Borrowing + Additional cash
• Maintenance Margin Requirement (MMR)
• Minimum
amount equity can be before
additional funds must be put into account
• Exchanges mandate minimum 25%
• Margin Call
• Notification from broker that you must put up
additional funds or have position liquidated
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3.8 Buying on Margin
• If Equity / Market value  MMR, then
margin call occurs
Market Value - Borrowed
 MMR
Market Value
• Solve for market value
• A margin call will occur when:
Borrowed
Market Value 
1 − MMR
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3.8 Buying on Margin
The percentage margin is defined as the ratio of the net
worth, or the “equity value,” of the account to the market
value of the securities. To demonstrate, suppose an
investor initially pays $6,000 toward the purchase of
$10,000 worth of stock (100 shares at $100 per share),
borrowing the remaining $4,000 from a broker. The initial
balance sheet looks like this
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3.8 Buying on Margin
The initial percentage margin is
If the price declines to $70 per share, the account balance
becomes:
The assets in the account fall by the full decrease in the stock
value, as does the equity. The percentage margin is now
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3.8 Buying on Margin
If the stock value in the Example were to fall below $4,000,
owners' equity would become negative, meaning the value
of the stock is no longer sufficient collateral to cover the
loan from the broker. To guard against this possibility, the
broker sets a maintenance margin.
If the percentage margin falls below the maintenance level,
the broker will issue a margin call, which requires the
investor to add new cash or securities to the margin
account. If the investor does not act, the broker may sell
securities from the account to pay off enough of the loan to
restore the percentage margin to an acceptable level.
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3.8 Buying on Margin
Suppose the maintenance margin is 30%. How far could
the stock price fall before the investor would get a margin
call? Let P be the price of the stock. The value of the
investor's 100 shares is then 100 P, and the equity in the
account is 100P− $4,000. The percentage margin is (100P
− $4,000)/100P. The price at which the percentage margin
equals the maintenance margin of .3 is found by solving the
equation
which implies that P = $57.14. If the price of the stock were
to fall below $57.14 per share, the investor would get a
margin call.
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3.9 Short Sales
• Sale of shares not owned by investor but
borrowed through broker and later purchased
to replace loan
• Mechanics
• Borrow stock from broker; must post margin
• Broker sells stock, and deposits proceeds/margin
in margin account (you cannot withdraw proceeds
until you “cover”)
• Covering or closing out position: Buy stock; broker
returns title to party from which it was borrowed
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3.9 Short Sales
Purchase of Stock
Time
Action
Cash Flow*
0
Buy share
− Initial price
1
Receive dividend, sell share
Ending price + Dividend
Profit = (Ending price + Dividend) – Initial price
Short Sale of Stock
Time
Action
Cash Flow*
0
Borrow share; sell it
+ Initial price
1
Repay dividend and buy share to
replace share originally borrowed
− (Ending price + Dividend)
Profit = Initial price – (Ending price + Dividend)
*Note: A negative cash flow implies a cash outflow.
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3.9 Short Sales
• Round Trips
• Long position
• Buy first, sell later
• Bullish
• Short position
• Sell first, buy later
• Bearish
• “Round trip” is a purchase and a sale
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3.9 Short Sales
• Required initial margin: Usually 50%
• More for low-priced stocks
• Liable for any cash flows
• Dividend on stock
• Zero tick, uptick rule
• Eliminated by SEC in July 2007
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3.9 Short Sales: Example
Suppose you are bearish (pessimistic) on Dot Bomb
stock, and its market price is $100 per share. You tell
your broker to sell short 1,000 shares. The broker
borrows 1,000 shares either from another customer's
account or from another broker.
The $100,000 cash proceeds from the short sale are
credited to your account. Suppose the broker has a
50% margin requirement on short sales. This means
you must have other cash or securities in your
account worth at least $50,000 that can serve as
margin on the short sale.
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3.9 Short Sales: Example
Let's say that you have $50,000 in Treasury bills.
Your account with the broker after the short sale will
then be:
Your initial percentage margin is the ratio of the
equity in the account, $50,000, to the current value
of the shares you have borrowed and eventually
must return, $100,000:
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3.9 Short Sales: Example
Suppose you are right and Dot Bomb falls to $70 per
share. You can now close out your position at a profit.
To cover the short sale, you buy 1,000 shares to replace
the ones you borrowed. Because the shares now sell
for $70, the purchase costs only $70,000. Because your
account was credited for $100,000 when the shares
were borrowed and sold, your profit is $30,000: The
profit equals the decline in the share price times the
number of shares sold short.
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3.9 Short Sales: Example
Suppose the broker has a maintenance margin of
30% on short sales. This means the equity in your
account must be at least 30% of the value of your
short position at all times. How much can the price
of Dot Bomb stock rise before you get a margin
call?
Let P be the price of Dot Bomb stock. Then the
value of the shares you must pay back is 1,000P,
and the equity in your account is $150,000 −
1,000P. Your short position margin ratio is
equity/value of stock = (150,000 − 1,000P)/1,000P.
The critical value of P is thus
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3.9 Short Sales: Example
which implies that P = $115.38 per share. If Dot
Bomb stock should rise above $115.38 per share,
you will get a margin call, and you will either have to
put up additional cash or cover your short position
by buying shares to replace the ones borrowed.
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3.10 Regulation of Securities Markets
• Self-Regulation
• The Sarbanes-Oxley Act
• Insider Trading
• Inside information: Nonpublic knowledge about
a corporation possessed by officers, major
owners, etc., with privileged access to
information
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